The deadline for implementation is Jan. 1, 2018, for calendar year publicly-held companies, and Jan. 1, 2019, for calendar year privately-held companies. Although the implementation date for non-public companies is over one year away, our dedicated Government Contractor practice specialists encourage clients to start evaluating the changes now to understand the impact on their financial statements.
In this article, we will provide an overview of the revenue standard’s main provisions, provide best practices for implementation methods, and identify key issues that may impact government contractors during implementation. This guidance will be especially beneficial to entities following the AICPA’s Industry Revenue Recognition Task Force for Aerospace & Defense.
Main provisions of the new standard
The new standard is more principle-based than current revenue recognition guidance and will require government contractors to exercise more judgement. The principle is based on a five-step model from the AICPA Revenue Recognition Guide:
Step 1: Identify the Contract with a Customer
The standard includes characteristics that need to be met for a contract to permit revenue recognition. In general, a contract exists if there is an agreement between a buyer and seller that creates enforceable rights and obligations for the two parties. Only when there is such an agreement is there any revenue to recognize under Topic 606. This step sets the base to which the rest of the steps in the model are applied.
Also included in this step is guidance on when to combine multiple contracts into a single contract for revenue recognition purposes, and what to do if a contract is modified, thereby changing the identified contract with a customer.
Step 2: Identify the Performance Obligations in the Contract
Among the rights and obligations that will be set forth in the contract (either explicitly or implicitly), are:
- 1. The right of the buyer to receive goods or services from the seller, and;
- 2. The obligation of the seller to provide those goods or services to the buyer.
Once the contract has been identified, the seller identifies what goods or services it has promised to provide to the buyer. The standard includes guidance on evaluating provisions of a contract to determine whether they should be regarded as creating promised goods or services.
If multiple goods or services are promised, the seller must determine whether each good or service is distinct from other goods or services in the arrangement, or must instead be combined with other goods or services to form a bundle that is distinct from other goods or services in the contract.
Each good or service that is distinct, or each bundle of goods or services that is distinct, is called a performance obligation under the standard. Performance obligations are then used as units that are evaluated for revenue recognition purposes in the rest of the model.
Step 3: Determine the Transaction Price
In addition to rights and obligations over goods or services to be provided, a contract will include:
- 1. The obligation of the buyer to pay the seller for the goods or services, and;
- 2. The right of the seller to collect that payment from the buyer.
Those provisions provide a starting point for determining the transaction price. Often, the payment terms are fixed and payment is due when goods or services are delivered. In that case, it is simple to determine the transaction price to be used in recognizing revenue.
However, the vendor needs to determine whether all amounts to be collected are appropriately reported as revenue. In addition, the contract may include terms that make the transaction price variable. For example, the transaction price could vary due to usage-based payments, award and incentive fees, rights of return or refund, or economic price adjustment.
Topic 606 explains when, and how much, variable consideration is to be included as part of the transaction price. This will generally require variable consideration to be included in the transaction price to the extent it is probable such consideration will become due under the contract.
Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract
In this step, the transaction price determined in Step 3 is allocated, or assigned, to the performance obligations identified in Step 2. Obviously, if there is only one performance obligation, this allocation is easy, as the entire transaction price is allocated to the single performance obligation. However, if there are multiple performance obligations, the transaction price must be allocated to those performance obligations.
Generally, this is done based on the stand-alone selling prices of the performance obligations in the contract. The stand-alone selling price of a performance obligation may be objectively determinable if the performance obligation is regularly sold on a stand-alone basis. If it is not, its stand-alone selling price must be estimated through a reasonable technique.
Once stand-alone selling prices for all performance obligations are estimated, the transaction price is generally allocated based on the relative values of the performance obligations, effectively allocating any discount in the contract to the performance obligations on a pro rata basis.
Step 5: Recognize Revenue When (or as) the Entity Satisfies a Performance Obligation
Once the transaction price has been allocated to the performance obligations in the contract, the amount of revenue allocated to each performance obligation is recognized when, or as, the entity performs the obligation as required by transferring the promised goods or services that make up the performance obligation to the customer.
A good or service is deemed to be transferred to the customer when the customer gains control over the good or service. A customer sometimes gains control of promised goods or services as performance occurs over time. In other instances, the customer gains control of a promised good or service at a single point in time, often when something is physically delivered to the customer.
When a performance obligation is satisfied over time, the seller must determine an appropriate measure of its progress toward satisfying the performance obligation, and then recognize revenue based on that progress measurement applied to the amount of the transaction price allocated to the performance obligation.
When a performance obligation is satisfied at a point in time, the seller must determine the appropriate point in time at which to recognize as revenue the amount of the transaction price allocated to the performance obligation.
Implementation methods
Full retrospective application: Recast of prior period financial statements (with an adjustment to opening retained earnings for the first year presented). For example, for a public company, 2016 and 2017 would be recast to reflect the adoption of the new standard presented in the 2018 financial statements. The cumulative adjustment would be reflected as of Jan. 1, 2016.
Modified retrospective application: Cumulative effect of initially applying the standard is recorded as an adjustment to opening retained earnings of the period of initial application. Under the same example, 2016 and 2017 would not be recast in the 2018 financial statements. The cumulative adjustment would be reflective as of Jan. 1, 2018.
Implementation issues and guidance
For government contracts, the type of contract will determine if there will be a change from current revenue recognition practices. For time and materials and cost-plus-fixed-fee contracts, as well as services-based firm-fixed-price contracts, there will be minimal change to the total revenue and timing of revenue recognized under the new revenue standard. Under more complex contracts (i.e., award fees under cost-plus contracts, or firm-fixed-price contracts where the entity performs manufacturing, design, development, integration, and/or production), applying the new standard will require careful analysis and consideration, and could impact the timing of revenue recognition.
The AICPA’s Industry Revenue Recognition Task Force for Aerospace & Defense has identified various revenue recognition implementation issues and continually updates the list of issues as discussions continue.
The following are some of the key areas to consider when implementing the new guidance as noted in the AICPA’s Industry Revenue Recognition Task Force for Aerospace & Defense.
Acceptable Measure of Progress – what to consider when measuring progress towards completion of performance obligations satisfied over time.
Accounting for Contract Costs – considerations for applying the guidance in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 340 for incremental costs of obtaining a contract, costs to fulfill a contract and amortization and impairment, to costs typically incurred in aerospace and defense contracts, including pre-contract costs and learning or start-up costs.
Variable Consideration – considerations for estimating the amount of variable consideration (incentive fees, award fees, economic price adjustments) in aerospace and defense contracts, the impact of subsequent modifications, and how to determine the amount of estimated variable consideration to include in the transaction price.
Significant Financing Component – considerations needed to assess whether a significant financing component exists in determining the transaction price for various types of aerospace and defense contracts.
Allocating the Transaction Price – considerations for determining how to allocate the transaction price to multiple performance obligations in aerospace and defense contracts.
Implementation plan for government contractors
The AICPA Financial Report Center developed an implementation plan that may be helpful as a starting point for developing your own implementation plan. Below are the high-level steps included in that plan.
- Designate the individual(s) responsible for overseeing implementation.
- Evaluate how the changes will impact how your company accounts for different types of revenue streams/contracts. Consider how the new standard will impact current performance metrics and compensation plans. Work with your auditor to discuss the completeness and accuracy of your analysis.
- Determine an implementation method (full or modified retrospective approach).
- Determine changes that may be needed within systems and/or software applications to facilitate revenue recognition under the new standard.
- Determine what interim disclosures may be required prior to the effective date.
- Develop a plan for implementation to incorporate the above steps, as well as train your staff.
- Educate the company’s management on the new standards and the impact you expect the changes to have on the company’s financial statements.
MGO has a dedicated Government Contractor practice with CPAs and industry specialists who are well-versed in the new standard and can assist in evaluating the impact of the changes on government contracts revenue recognition and financial reporting. We also assist our clients in implementing the new standard.
To learn more about how we can help, let’s talk.
]]>By Scott P. Johnson, CPA, CGMA
Partner, Macias Gini & O’Connell LLP
State and Local Government Advisory Services
I have spent most of my professional career over the past 35 years serving government agencies and focusing on performance improvement, accountability, and transparency. I recognize the need for continuous monitoring and oversight in the public sector to ensure performance, public accountability, and stewardship of public resources. While participating on a number of professional panels and presentations throughout my career, I have often stated that I embraced the auditor and have welcomed them with open arms into the organizations that I had responsibility over. Why? Because I see auditors as an independent and objective lens, adding value to review and evaluate performance and to make recommendations for improvement. The organizations I have had the pleasure to work for took public accountability very seriously and supported performance improvement as a means to better serve their communities and stakeholders.
Much like a traditional CPA firm can provide different types of services related to an entity’s financial statements, i.e., audit, review, or compilation, based on need, when government agencies are considering an independent evaluation of performance of their programs or operations, the CPA firm’s advisory or consulting arm can step in and offer a number of engagement types based on the agency’s unique needs: consulting services engagements, attestation engagements (e.g., agreed-upon procedures), and performance audits. It all depends on if, and at what level, assurance is needed. The primary driver of what type of product should be considered is typically based on, for instance, issue complexity, taxpayer concerns or expectations, statute requirements, or increased need for transparency on the efficiency and effectiveness of operations. While the driver of the engagement may differ, time constraints and budget are also determining factors.
This is the first article in a three-part series focusing on performance audits. The primary focus of this article is to discuss the differences of the three aforementioned types of engagements – consulting services, agreed-upon procedures, and performance audits – and to provide guidance when a performance audit might be an option.
It is important to identify the differences between (1) performance audits, (2) consulting services engagements, and (3) agreed-upon procedures attestation engagements. On numerous occasions throughout my government service career and also while serving clients, questions have come up regarding the objectives sought, the scope of the engagement, and the engagement type when considering an evaluation of performance for a particular program or area of operations. Each of these engagements differ in purpose and reporting requirements, as well as potential cost, as shown below in Figure 1.0. These engagements are governed by different standards, formal reports are not always required for each, and independence is not always required (i.e., consulting services).
Performance Audits Defined
Performance audits are defined as engagements that provide objective analysis, findings, and conclusions to assist management and those charged with governance and oversight to, among other things, improve program performance and operations, reduce costs, facilitate decision making by parties with responsibility to oversee or initiate corrective action, and contribute to public accountability. *1
Furthermore, GAGAS states that management and officials of government programs are responsible for providing reliable, useful, and timely information for transparency and accountability of these programs and their operations. Legislators, oversight bodies, those charged with governance, and the public need to know whether (1) management and officials manage government resources and use their authority properly and in compliance with laws and regulations; (2) government programs are achieving their objectives and desired outcomes; and (3) government services are provided effectively, efficiently, economically, ethically, and equitably. *2
Agreed-Upon Procedures (AUP)
Based on my experience, it usually comes down to identifying a few factors that determine the engagement. First, the agency must determine the purpose and scope of the work, specifically what questions they would like to have answered. These questions can be broad or very narrow. For example, in an AUP, management may make an assertion about whether a subject matter is in accordance with, or based on, established criteria that is the responsibility of a third party and hires a CPA to add credibility to that assertion by performing specific procedures to test compliance with the criteria. If an agency needs to know something very specific and wants an independent party to perform specific procedures and tell them what was found, then an AUP is appropriate. However, an AUP report does not provide recommendations, an opinion, or conclusion about whether the subject matter is in accordance with, or based on, the criteria, or state whether the assertion is fairly stated. While the agency may want to use an AUP, some key steps that are taken in consulting engagements and performance auditing, such as planning, are not required in an AUP engagement. Also, risk is not assessed in developing the scope, nor does the auditor use a risk-based approach, which is required in a performance audit. Finally, in an AUP, auditors do not perform sufficient work to be able to develop elements of a finding or provide recommendations.
1 See Paragraph 1.21 of GAGAS.
2 See Paragraph 1.02 of GAGAS.
Consulting Services Engagement vs. Performance Audit
For a consulting services engagement or performance audit, the initial questions are then turned into the objectives of the engagement. If the agency wants an objective review of operations or a program to assist them in making decisions, for example, to assess the management of specific funds, and wants findings and recommendations to improve operations, then the agency should discuss the options of a consulting services engagement or a performance audit. From here, the decisions are truncated. The agency needs to consider whether the report is for an internal audience, such as governing officials, management, or staff, or an external audience, e.g., a regulatory agency or the public. If the communication is intended for internal use, then a consulting services engagement with observations and recommendations may suffice. For these engagements, findings, recommendations, and a conclusion is provided to assist management in decision making. Or, an independent third party, such as a CPA or an internal auditor, may be asked to answer the engagement’s objectives to an external audience, in which case a performance audit may be more appropriate due to the need for an independent, objective report that can withstand scrutiny and is subject to peer review. Sometimes there isn’t a choice; some agencies are bound by the government code or local ordinance to conduct audits under GAGAS.
Performance audits are typically the more costly engagement type of the three, given the amount of work required to conduct an audit and adhere to stringent standards. As we’ll explore in later articles, performance audits conducted under GAGAS provide the highest level of assurance among the three options, based on the level of work required. These audits involve developing the required elements of a finding and the documentary evidence required for planning, fieldwork, and reporting. The amount of work involved is much greater than in consulting services engagements, where observations and recommendations will suffice. Consulting services engagements are not audits and, therefore, offer no assurance. Similarly, in attestation engagements, where only specific procedures are performed, no assurance is provided. *3
Conclusion
Having been on both sides of deciding what engagement to recommend, either for an agency I worked at or to a client, it’s important to discuss the level of work required for each engagement type, the number of hours required to do the work under the appropriate standard within a reasonable time period, and the available budget. Finally, and most importantly, clients should understand that performance audits and consulting services engagements each have their place and serve unique purposes. A performance audit offers independence and objectivity at a step above a consulting services engagement, and might be the best option if a rigorous audit of a program or agency is needed. This is where the consideration of the agency’s need is paramount. There may not always be the budget or time available to conduct a comprehensive performance audit, nor a need for an in-depth evaluation or a legislative requirement to do so. In these instances, a consulting services engagement is a good option, especially when time and budget are factors. A consulting services engagement can provide a sufficient report with recommendations and advice. However, it’s important to make the agency aware of the limitations of non-audit services. In addition, the audience of the final report product and any regulatory requirements should strongly influence the decision-making process.
Forthcoming articles in this series will drill down and focus in more detail on the professional standards associated with performance audits as compared to other types of engagements, “why” an agency would want a performance audit instead of a consulting engagement or an agreed-upon procedures engagement, when a performance audit would be recommended, what key factors should be considered, and what are the expectations of the audience of the report. The third article in this series will focus on the reporting elements of a performance audit and a sample performance audit report.
*3 Attestation engagement standards are covered in GAGAS Chapter 7, and include agreed-upon-procedures, reviews, and examination engagements. Attestation examinations have the highest level of assurance, as an opinion is given; not so for the others. Auditors may use GAGAS in conjunction with other professional standards such as American Institute of Certified Public Accountants (AICPA), International Auditing and Assurance Standards Board (IAASB), or Public Company Accounting Oversight Board (PCAOB) standards. For financial audits and attestation engagements, GAGAS incorporates by reference for AICPA Statements on Auditing Standards and Statements on Standards for Attestation Engagements. In addition, the AICPA promulgates the consulting standards. AICPA standard committees have taken the position that only the U.S. Government Accountability Office (GAO) sets performance audit standards.
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SOURCES OF INFORMATION AND DOCUMENTATION CONSIDERED
- Government Auditing Standards, issued by the Comptroller General of the United States
– July 2018 Revision (effective for performance audits beginning on or after July 1, 2019; effective for attestation engagements for periods ending on or after June 30, 2020; early implementation is not permitted) - United States General Accounting Office. Best Practices Methodology – A New Approach for Improving Government Operations. May 1995
About the Author
Scott Johnson has 35 years of experience in government administration, with a focus on successfully overseeing internal service operations including; debt management, information technology, human resources, municipal finance, and budget. He has led large and mid-sized operations for California government agencies including the cities of Santa Clara, Milpitas, San Jose, Oakland, and Concord and the County of Santa Clara. Scott is a past president of the California Society of Municipal Finance Officers (CSMFO) and a member of the AICPA Government Performance and Accountability Committee (GPAC). He is currently a partner with Macias Gini & O’Connell LLP (MGO), leading the Advisory Services sector specializing in State and Local Governments, based out of California. He welcomes any questions or comments via email: sjohnson@mgocpa.com.
Greta MacDonald, MPA – Special recognition is given to Ms. MacDonald for her contributions and research for this article. Ms. MacDonald is a Director with MGO in the State and Local Government Advisory Services division. She has over 17 years of experience conducting over 35 performance audits in accordance with GAGAS, which is her specialization area.
Disclaimer: The views expressed in this article are those of the author and do not reflect the official policy or position of the GAO, AICPA, or Macias Gini & O’Connell LLP.
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